Michael Howard does not seem like a man who is easily upset. The softly spoken Scot, who heads Prudential Portfolio Management Group’s alternatives programme, does not even get fired up by fees.
Does he, for example, think it is wrong that investors pay management fees on committed, rather than invested capital? It is an often-raised bone of contention among other limited partners.
“It’s a good question,” he says, and after a short pause concludes this issue is not something he has strong views on. “It all comes out in the J-curve and the IRR at the end of the day.”
When he does sound something like a note of concern, it is on the use of subscription credit lines.
“If people are using credit facilities for a long period of time, and you are paying fees on committed capital… you could argue that is a double whammy”
“If people are using credit facilities for a long period of time, and you are paying fees on committed capital… you could argue that is a double whammy.”
Howard is responsible for a portfolio of £5 billion ($5.7 billion; €5.6 billion) split across private equity, infrastructure, hedge funds and other niche strategies. Across both infrastructure and private equity, Howard says his teams have seen terms “creeping on” when it comes to how long credit facilities can be used for, from three to six months, to between 12 to 18.
“When the facility appears to be used to deliberately lever the fund, it is going beyond the reason for having it in the first place,” he says.
Howard says his teams, when going through legal and operational due diligence – “through the LPA with a fine-toothed comb” – want to understand why they are using a credit facility and under what circumstances. “We will generally try to challenge [managers] saying ‘Look, do you need this for that length of time? What you have just described to us requires a facility for six months; why have 18 on your prospectus?’”
And does it make a difference?
“We get some wins, and we get some pushback and we just have to make a commercial decision,” Howard concludes.
The issue Howard has with prolonged use of credit facilities is the problem it presents to investors regarding capital allocation.
“If you are collecting all the expenses and then clearing it off in three months’ time, then that is fine,” he says referring to what might be considered the more conventional use of a credit line. “If there is a long period of leverage in there, then that is an issue, because it means we will be underweight [against] our target and have to make a decision as to where we put that money that should have been invested in private equity.”
“Listed private equity?” I ask naively.
“Then you have two exposures,” Howard replies. “You are introducing more leverage into the portfolio. If you redeploy it elsewhere then your programme is levered… which is great when everything is going up.”
Capital left in cash – as it needs to be – earns an effective negative return based on the costs of the credit facility. I ask whether this is a genuine problem for PPMG as an investor or just a concern for Howard that the wider LP community may be encouraged to introduce additional leverage into their portfolios.
“I guess it’s just not the free lunch that people think it is,” he responds.
Howard’s remit gives him sight over numerous different asset classes – some more esoteric than others. Our conversation takes in buy-to-let mortgages, aircraft leasing, direct lending in Asia, Irish real estate, and insurance-linked securities – all areas that Howard’s team have either deployed capital or are working to do so.
Back to the topic of private equity though, and the things on Howard’s mind seem to be the standard laundry list for the institutional investor with a mature PE programme: fund sizes creeping up (“on occasion our team is having to not re-up based on fund size”) and, of course co-investment, and how to do more of it (“it’s clearly a good way of averaging down fees”).
“We already have a reasonably established co-investment programme in the US but it makes sense for us to establish a bigger programme going forward”
In the US, around two-thirds of the private equity programme is invested in funds and one-third directly through co-investments. In Europe, co-investment is less prevalent, says Howard. “It has been a slower market to develop, but is starting to happen more at the larger end,” he says, adding that the team in Europe may well up their co-investment activity if there are more opportunities.“We already have a reasonably established co-investment programme in the US,” he notes, “but it makes sense for us to establish a bigger programme going forward. We are not unique in this regard, but it will be interesting to see how the industry develops.”
Around £2 billion of PPMG’s alternatives portfolio is allocated to private equity. Over time Howard sees the overall allocation to the asset class increasing from its current 2.5 percent up to around 3.2 percent of the investment portfolio. “It has been very accretive, so it makes sense,” he says, without giving more detail on the overall private equity returns.
The group’s private equity portfolio is dominated by buyout funds and around 15 percent of it is invested at the large end of the spectrum, in funds of more than £10 billion. Like many investors, PPMG has become a little wary of the largest end of the buyout market, but is not avoiding it altogether. “Generally we are not allocating huge amounts of capital to the very largest funds,” says Howard, “but we do have a few in the portfolio. We are focused more on the mid-market because we think there is a premium to be picked up there.”
In today’s environment, enlarging one’s private equity portfolio is easier said than done. While commitments to private equity funds globally have hit new highs, the amount of capital actually being drawn down and invested is not keeping pace. Couple this with the fact that private equity funds have been taking advantage of market conditions to sell “everything that hasn’t been nailed down”, as Leon Black put it in 2013, even maintaining a private equity allocation can prove a challenge.
“It means we are making slightly larger commitments,” says Howard, “but quite frankly I would rather our managers use their discretion to choose the right deals rather than feel obliged to quickly get money out of the door.”
“Obviously if it persists for a few years, then you have a J-curve starting to kick in,” Howard continues, “but for now I am quite happy if it is a one or two-year phenomenon to see people harvesting and being cautious about how they deploy.”
It is clear from the conversation that co-investment will play a significant part in growing the private equity allocation. But is this just to squash fees, boost performance or simply get more capital in the ground? “When you do the maths, taking out two-and-20 gives you a decent advantage from the start,” says Howard, who adds Prudential’s analysis of industry data suggests that returns from co-investment programmes “largely come in in line with fund returns” gross of fees. PPMG’s own co-investment programme, he notes, has outperformed its funds programme over time, net of all fees.
Is Howard concerned about the capital currently being deployed into a market characterised by high entry valuations and the effect this is likely to have on returns?
Not really. While it remains a separate allocation from public equities within the portfolio, Howard increasingly views private equity as a substitute for public equity. And at the moment the relative gap between richly priced publicly listed companies and slightly less richly priced private investments means PE remains an attractive option.
As long as it continues to deliver between 300 and 400 basis points more than the public market equivalent – as it has done historically for PPMG – then private equity is doing its job, says Howard.